Bankruptcy Bulls

By

Neil A. Martin

Dec. 17, 2001 12:01 a.m. ET

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When food giant Nestl&eacute; disclosed last week that it had received the green light from the American government for its $10.3 billion acquisition of pet-food maker Ralston Purina, no one was more relieved at the deal's completion than David J. Winters, president and chief investment officer of Franklin Mutual Advisors, which runs a series of mutual funds from its Short Hills, New Jersey, headquarters.

A portfolio manager of the firm's $3.4 billion Mutual Discovery Fund, which has most of its assets in foreign securities, Winters had been buying shares of Ralston Purina ever since Switzerland-based Nestl&eacute; announced last January that it planned to take over the St. Louis-based company and create the world's largest pet-food concern.

"We bought Ralston as an arbitrage situation in the belief that the deal would get done and generate an attractive return," says Winters.

He was right on both counts.

The acquisition closed last Wednesday with a cash bid by Nestl&eacute; to buy all outstanding shares of Ralston Purina for $33.50, compared with Winters' average buying cost of around $31. He also made money on Nestl&eacute;, which he bought in the aftermath of the September 11 terrorist attacks when European stocks plummeted and Nestl&eacute; dipped to the low 300 euro ($271.22). It's now trading around 340 euros ($307.38). (The Swiss company's common rose by 1.5% in the day following the deal-completion announcement.)

"Arbitrage is all about timing and the deal closing," Winters says. "This was an opportunity to earn an attractive rate of return," he explains. "With a cash tender from a Triple-A buyer like Nestl&eacute;, we thought it worth the risk -- and it was," he adds.

Winters is not shy about a little risk "as long as it is accompanied by the potential of a substantial upside," he says. "What we are trying to do is to make money for our shareholders in good times and in bad times." He adds, "We want to be an all-weather fund."

Besides scouring the globe for arbitrage opportunities, Winters also currently invests about 10% of his fund's assets in the distressed securities of bankrupt and reorganizing companies in Europe and the U.S.

In addition, he also is on the lookout for what he describes as "ignored, unloved and neglected" companies trading at deep discounts to intrinsic value.

"This fund favors small and mid-size firms that are dirt cheap," notes a recent report on Mutual Discovery by the fund-tracker Morningstar. "While its penuriousness has sometimes been a problem, it has paid off over time," the report adds.

To be sure, most funds that invest in foreign stocks are down significantly this year. But Winters' fund is off by only 0.82% through last Thursday, placing it fourth among 108 foreign-stock funds, according to Morningstar.

During the previous 12-months ending last Wednesday, the fund earned 2.61%, according to Morningstar. It is ahead of its benchmarks and most of its peers by a wide mark with an annualized return of 12.16% over three years, and 11.28% over a five-year span. Since its inception in November 1992, the fund has achieved a cumulative return of 241%. The fund's Class A shares were awarded a "five-star" overall rating (five is "best" and one is "worst") from Morningstar for a three-year cumulative return of 39.38%, which placed the fund eighth among its global peers.

Or, to put it another way, if you had put $10,000 into the fund since its 1992 inception, your investment would be worth $37,375 today, versus $23,983 for the MSCI World Index, and $12,507 in terms of inflation.

Unlike some fund managers, who select foreign companies based on their region or the type of business they are in, Winters picks stocks like most domestic U.S. fund managers do, taking a bottom-up approach. That means he goes through the foreign corporate roster, company-by-company and stock by stock. "With a focus on value," he hastens to add.

"We like to go off the beaten path to look for stocks," he says.

One example of a neglected stock in Mutual Discovery's portfolio is
Cendant,
the hotel, resort and car rental operator, which Winters bought two years ago when "it was unloved," he says.

While Cendant shares are still under a "real cloud" from an accounting-fraud investigation several years ago, Winters concluded that they were "significantly undervalued." It has "a solid business and strong cash flow even in a recessionary environment; and a management team determined to restore the company to its former prominence," he says.

The stock has more than doubled in price since Winters bought it. This year alone it has appreciated by 96%, compared with a 14% drop in the Standard & Poor's 500 Index.

A similar contrarian approach resulted in the addition of the Franco-Spanish tobacco group
Altadis,
whose stock price has appreciated by 8% this year, and the entertainment and direct-selling conglomerate
USA Networks,
which has gained 25% in the same time period.

Winters is particularly bullish about cigarette-maker
British American Tobacco
(BTI), which is based in London. He believes it has less exposure to legal liability in American courts than its U.S.-based competitors. "It currently yields 6%, give or take, and trades at eight times next year's earnings," he adds. "Management has been doing a very good job of running the business and generating returns."

While he likes companies like BAT that he feels are run for its shareholders, Winters isn't averse to a little shareholder activism. We are willing to make "our views known to management about what needs to be done, including making recommendations for directors or running proxy contests to elect directors to a board," he says.

But what Winters likes best is what he calls "crawling over the carcasses" of distressed or failed companies and projects. In short, buying the bonds of companies that are (or soon will be) involved in bankruptcies or financial restructurings.

"We're bullish on bankruptcy," he says. "We try to buy a dollar bill for as little as we can, and get the assets for big discounts."

The lengthy legal proceedings -- typically several years long -- can be worth the wait. Over the years, Winters estimates that this business has generated returns of 15%-20% at a compounded annual rate.

"We've earned very good returns in bankruptcies and expect there will be more opportunities over the near-term," he adds. "What we are simply trying to do is make money for our shareholders in good times and bad times," Winters says.

Winter's fifth-largest holding -- the London-based property-developer
Canary Wharf Group
-- represents probably the ultimate play in the fund manager's invest-in-distress philosophy. Canary Wharf, Britain's second-largest developer, ran into trouble during the early 1990s when bureaucratic delays, a depressed global economy and financial problems forced a suspension of the landmark Central London project that bears its name.

"You had a confluence of factors in the early 1990s that created a classic distress situation," Winters recalls. "But if you had a longer-term view you could see that Canary Wharf was valuable and would be even more so over time."

With a group of other investors, Mututal Discovery participated in a partnership that bought out the banks that had foreclosed on Canary Wharf. "Canary Wharf turned out to be an enormous home run for us," says Winters, who declines to give a precise rate of return.

For example, Mutual Discovery recently made money buying senior obligations -- bonds and bank loans -- of two high-profile bankruptcies this year -- that of commercial-lender
Finova Group
last March, and the distressed-utility Pacific Gas & Electric, which filed for court protection last April in an offshoot of the California energy crisis.

Finova's bond prices later jumped after court approval of a plan for a bailout led by investor Warren Buffett, while PG&E's bonds have rallied in the wake of an easing of the energy crisis in the Golden State.

"We bought Finova's bonds in the 50s and sold them in the 90s," Winters says, "and we purchased PG&E's in the 60s and they are now trading in the low 90s."

As underscored by the Nestl&eacute;-Ralston Purina deal, exploiting potential value growing out of mergers and acquisitions is one of Mutual Series' three major investment approaches.

"We are very interested in the deal market as a way to invest our cash and also because it helps us value what businesses are worth and understand the underlying values of our holdings," he explains.

Arbitrage applies, he says, to companies in the process of being acquired that he is adding to his holdings, or to companies already in his portfolio that are being taken over by some other firm.

"Either way we look at the spread between the company's market price and the price being offered by the buyer and figure out whether the annualized return is attractive enough to sell the holding or add it to our portfolio," he explains.

"We have found over time that arbitrage is a good way to invest our cash and to generate the kind of returns that are less correlated to the overall market," he explains. "And it also makes us sharper about what a business is really worth."

For example, Winters recently unloaded shares of Austria Tabakwerke, the Austrian tobacco monopoly, which was acquired last June by the British tobacco group Gallagher for 85 euro ($72.50) a share, a considerable premium to the market and well above the 50 euros ($40) that Winters originally paid for the stock.

"We knew it was in a consolidating industry, shares were cheap and when the spread between the cash bid price and its market price became so tight, we decided to clip the coupon, sell the shares and take the money and run," he says. "It all worked out rather nicely."

Although the pace of mergers and acquisitions has slowed recently, Winters believes his arbitrage activity will pick up in the months ahead.

"As the world continues to slow down in terms of economic growth, corporations will try to buy growth," Winters says. "So we believe there will be at some point a pickup in deal activity."

And if not, there will always be undervalued stocks to peruse and the carcasses of dead companies to pick up.

"The corporate casualty rate increases dramatically during recessions," Winters says. "That's an environment in which we generally do very well."

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